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Your investment success: Skill vs. Luck

Has your investment success so far has been based on luck?

If it is you are unlikely to be successful over the long term as at some point your luck will run out, most likely when the bull market ends.

But how do you know if you have been lucky or if your investment success is based on skill?

It’s easy to confuse the two. And I am sure you have never met an investor that has said his success is only based on luck.

So how do you determine if you are a skilled investor?

Knowing the difference is especially important if you invest in funds. You want to determine, preferably before you invest, if your fund manager’s track record is based on luck or if she is really a skilled investor.

I have read and thought about how to tell skill and luck apart a lot.

Not because I wanted to apply it on someone else. I wanted to know if I have so far just been lucky or if I have some skill as an investor. For if I have just been lucky I want to give my money to someone skilful as soon as possible before I lose everything.

The best writing on the subject I could find is an article by someone I admire and have followed since at least 2004.

His name is Michael Mauboussin and he is chief investment strategist at Legg-Mason Capital Management Inc.

You can find more articles by Michael here: Michael Mauboussin resource page.

In the article Untangling Skill and Luck – How to Think About Outcomes – Past, Present, and Future published in July 2010 Michael says:

“Outcomes from many activities—including sports, business, and investing—are the combination of skill and luck.

Most people recognize that skill and luck play a role in results, yet they have a poor sense of the relative contribution of each.

The ability to properly untangle skill and luck leads to much better thinking about most day-to-day outcomes, and allows for sharply improved decision making.”

The article is quite long, 27 pages, but definitely worth reading as in it he goes on to show:

  • Why it’s important to think about the blend of skill and luck in an outcome
  • How to determine the blend of luck and skill
  • How to determine skill and luck in sports, business and investing

Towards the end of the article Michael got into what I think will really interest you. The part on skill in investing.

He says:

“Even if we can reasonably conclude that there are skilled investors, the challenge is to identify them before they deliver superior results.

Skill in investing, like other probabilistic activities, is a process that incorporates analytical, psychological, and organizational considerations.

If nothing else, the discussion of skill and luck makes clear why focusing on outcomes is less useful than focusing on process.

If luck nets to zero over time—you win some, you lose some—then long-term results depend on the process.”

He goes further and gives his thoughts of what makes a good investment process.

He divides investment process into three parts.

First, an analytical advantage and the ability to invest the appropriate amount of capital when you have an advantage.

Michael defines the core of an analytical advantage as the ability to distinguish between fundamentals and expectations reflected in the price of the investment.

An analytical advantage should also not be confused with investment style which may outperform and underperform from time to time. A true analytical edge should lead to outperformance in up and down markets regardless of what investment style is doing well.

Having an analytical advantage is however part of the analytical task.

The next challenge is to properly build a portfolio to take advantage of the opportunities you have identified. The most common mistake when building a portfolio is the sizing of positions. Positions can be either too small or too large.

Positions in more attractive opportunities should form a larger part of your portfolio than less attractive opportunities.

For more information on portfolio structuring take a look at the article How to structure a portfolio.

With position sizing be careful of making positions too large. We all make mistakes and do not want to lose everything if something completely unexpected happens.

Remember what happened to Long-Term Capital Management?
 

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The second part of a good investment process is psychological or behavioural.

Not everyone has a temperament that is suited to investing and skilful investors approach markets with levelheadedness.

Michael quotes skilled investor Seth Klarman, founder and president of the highly-successful Baupost Group, who said:

“Value investing is at its core the marriage of a contrarian streak and a calculator.”

Most skilful investors have a contrarian streak, but Michael makes the important point that it’s not enough to be contrarian as sometimes the market is right. Your aim should be to be contrarian when it gives you an edge.

Your goal should be to actively think of different points of view, test them with data, and if you have enough of a margin of safety to back your opinion and invest.

What you should also do is take steps to mitigate, the biases that come from common human traits. Some of these biases include overconfidence, anchoring, the confirmation trap, and the curse of knowledge, to name just a few.

Overcoming these pitfalls is not easy, especially at emotional extremes. Techniques that are helpful include expressing views in probabilistic terms, constantly considering base rates, and maintaining a decision-making journal.

The last component under this point is keep a correct mindset towards the market Michael call a “Mr. Market mindset” from the idea of Benjamin Graham.

“Mr. Market, a “very obliging” fellow who offers to sell his shares to you or to buy yours. Mr. Market shows up every day, but is sometimes very optimistic and, fearful that you will snatch his shares at a low price, posts a very high price. On other occasions he is distraught, and seeks to dump his shares at a bargain basement price.”

The lesson is that the market is there to serve you but not to educate you. Accept an offer when you think it’s attractive. Apart from that prices are to be ignored.

The third and final part of a good investment process addresses organisational or institutional constraints.

Here the most important point is how to manage the interests of your investment advisor.

First I would advise that you look at your own incentives of why you invest your own money. Is it for excitement, to have something to talk about or to generate acceptable long term real returns after tax? Here you must make sure that your overall long term goal fits with your incentives and make sure you align them.

For example if you invest for excitement but want market beating long term returns it would be better to invest only a small part of your money yourself – for excitement. But give the bulk of your money to a trustworthy fund manager.

When choosing a fund manager its important to think of her incentives for she may have interests that are different to yours.

As a fund managers who is paid based on fees on assets under management she may seek to prioritize asset growth over high returns. Actions to serve this priority may include heavily marketing of products that have been successful recently, launching new products in hot investment areas and managing portfolios to look similar to their benchmarks.

Michael mentions Charley Ellis who made the point that he distinguished between the profession and business of investing saying:

“The profession is about managing portfolios so as to maximize long-term returns, while the business is about generating earnings as an investment firm.

Naturally, a vibrant business is essential to support the profession. But a focus on the business at the expense of the profession is a problem. Stated differently, you want the investment professionals focused intently on finding opportunities with edge and building sensible portfolios.”

Something else to consider is also that fund managers are influenced by career risk.

In order to generate market beating long term returns fund managers frequently have portfolios that look very different than the index or benchmark. This naturally leads to their returns differing from the of the index or benchmark.

If the time horizon of the investment company or the clients is shorter than the time horizon of the fund manager’s investment approach to work, even skilled managers run the risk getting fired.

To avoid this fund managers have learned not to deviate to far from the index or benchmark.

As I said the article is really a worthwhile read, print it out and spend an hour reading through it. You will not think of investing the same after that.

Here is the link again:
Michael Mauboussin – Untangling Skill and Luck – How to Think About Outcomes – Past, Present, and Future

In summary I here is a checklist to help you become a skilful investor:

  1. Do you have an analytical edge? What is it?
  2. Do you have a process of sizing your bets?
  3. Do you have a contrarian nature?
  4. Do you have a process in place to make sure your contrarian view is correct?
  5. Do you have a process of managing investor biases (overconfidence, anchoring, the confirmation trap, and the curse of knowledge)?
  6. How do you ensure that you do not fall under the spell of Mr. Market?
  7. Do you know what your real motivation is for investing?
  8. Does this motivation fit with your overall long term financial objectives?
  9. How do you plan on managing the incentives of you and your investment advisor or fund manager that are not the same?

Your investment process analyst